IFRS and Transfer Pricing as per Income Tax Act, 1961
The bundle of IFRS that we have in the pipeline is no kith and kin for the existing Transfer Pricing concepts. IFRS dwells predominantly on the ‘Fair Value’ concept. Majority of these standards (for e.g. IFRS-3, IFRS-5, IAS-40, IAS-39, IAS-18 etc.) are vigilantly drafted as an attempt to make the financial statements look in conformity to the market conditions and give more facelift to the present accounting system.
Let us first get reminded that a separate standard on Computation of Fair value is yet to be exposed out. The very basic definition of Fair value (as defined in IFRS) is “The amount at which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s-length transaction”. At the outset, this definition should not be misconstrued as covering only barter transactions, since the word used is ‘asset could be exchanged…..’ The underlying intention is create a comparable value of an equal or equivalent asset that is prevalent in the market. The definition will automatically research for the current replacement cost of an asset on a periodic basis. Ignorance is no bliss with the usage of the word’ knowledgeable’ as a necessary attribute to the trading parties. This presumes Ignorant parties are likely to get influenced by external forces. Luckily or not, the term arms length transaction is undefined in these standards.
The Income tax Notification No.23/2010 carries ample guidance for computation of Fair Market value of shares and securities, jewellery and archeological paintings and other arts. All these have one rule in common; to adopt the price fetched in open market or if obtained from a registered dealer adopt the Invoice value. There is nothing explicitly stated here whether to apply the same rule in a controlled transaction. But the basic rule of interpretation is where there is a specific law (Sec.92) it will override the generic one unless the latter is made non-obstante. Hence this Notification should be restricted to uncontrolled transactions. Secondly, even otherwise, adopting the invoice value ‘as such’ is not the fair approach for a controlled transaction.
Now let us move on to the transfer pricing perspective. Our Income tax law is a notch above by defining the term ’Arms length Price’. Needless to say, unless there is an Arms length price there is no Arms length transaction. One of the popular methods of determining Arms length price is the ‘Comparable Uncontrolled Price’ method (CUP) which is also one of the subject matter of Rule 10B of the IT rules. The method prescribed in the IT Rules is reproduced below,
“Comparable uncontrolled price method, by which,—
(i) The price charged or paid for property transferred or services provided in a comparable uncontrolled transaction, or a number of such transactions, is identified;
(ii) Such price is adjusted to account for differences, if any, between the international transaction and the comparable uncontrolled transactions or between the enterprises entering into such transactions, which could materially affect the price in the open market;
(iii) the adjusted price arrived at under sub-clause (ii) is taken to be an arm’s length price in respect of the property transferred or services provided in the international transaction”
It is very evident from the above verses that as a first step, one has to create a benchmark transaction which should be comparable and uncontrolled. The term Uncontrolled transaction is defined as “a transaction between enterprises other than associated enterprises, whether resident or non-resident” (It is of course difficult to understand why law presumes lack of influence in transactions not involving associated enterprises). But quite cleverly this confusion is removed in the definition of the term Arms length price which reads as below,
“Arm’s length price” means a price which is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled conditions”
Here there is a clever reference to uncontrolled conditions rather than uncontrolled transactions. Otherwise the term arms length price would have got confined to a transaction involving only non associated enterprises and defeat the basic intention of the Government to arrive at uncontrolled price (read the definition of uncontrolled transaction).
In fact all the other methods of determining ALP as per IT rules being Retail price method, Cost plus method etc also carry a step containing an ‘Adjustment factor’ to customise the value.
On Preliminary analysis it can be found that the basic difference between a Fair value as per IFRS and the arms length price (ALP) arrived as per the Income tax rule lies in the nativity of these values. Fair value definition accepts any uncontrolled (arms length) transaction as the benchmark, whereas the ALP computation under the Transfer pricing rules require a detailed study and adjustment for factors which affect the price in the open market (refer step (ii) in ALP computation above).This means there is a need to eliminate the effect of differences in the environmental factors governing the international transaction and the comparable uncontrolled transaction.
The following are some of the observations in the light of the above discussions,
1. A minimum two different set of books of accounts would be required to satisfy the Income tax department and ROC to the extent of these valuation differences. This is also a widespread opinion.
2. In future there may be rules prescribing that the management should be devising a fair value policy and also maintain a specific set of documentation(similar to Transfer pricing) for Indian GAAP purpose. For e.g. detailed workings on the fair value, the benchmark records, company profile etc.
3. Income tax law applies Arms length price only in a transaction involving Associated enterprise and not otherwise. We can say that the Fair value can approximate the ALP better than the Cost, if Cost is a controlled amount. Assuming IFRS requires initial recognition on Cost basis. Upon Initial recognition under IFRS there could be a different basis for tax purpose in the form of an ALP determination. This would result in permanent differences which carry no deferred tax impact.
4. However if there would be a subsequent valuation at fair value, reversible differences (Temporary) can arise at the initial recognition depending on the numbers. It may be noted that as per IAS-40 on Investment property, there is an option to have subsequent measurements on the Balance sheet dates at Cost or Fair value model. Therefore Corporate may consider adopting Fair value model subsequently for ALP approximation. To consider a hypothetical example, if the asset is bought at Invoice price of Rs.100/-, the ALP is computed to be Rs.200/- and the fair value as per IFRS is Rs.150/-. The initial recognition under IAS-40 would have happened at Rs.100/-, but for Tax purpose the basis would be Rs.200/-. Though apparently the difference of Rs.100/- is not a reversible difference as per IAS-12 (neither AS-22), in the next balance sheet date the valuation is done at Fair value of Rs 150/-. Hence to the extent of Rs.50/- (200-150) it indicates existence of a possible reversible difference at the inception itself. But can the assessee be required to create any deferred tax asset or liability for this possible reversing difference by using an estimated future Fair value and discounting the same? May be some guidance is required on this. If the asset is in a non depreciable class that is revalued up later, SIC 21 says that the deferred tax liability or asset should be calculated using the tax rate which relates to capital profits rather than the rate applicable to earnings.
However for Revenue the definition given in IAS-18 is “The gross inflow of economic benefits during a period arising in the course of ordinary activities when those inflows result in increases in equity, other than increases relating to contributions from equity participants”. Revenue recognition under IFRS does not seem to create any difficulty in tax alignment, since the definition embodies the entire gamut of economic benefits from the particular transaction which is also the destiny of ALP computation. So we have higher chances for an alignment with tax numbers.
To sum up, the ALP computation as per Income tax act is scientifically ahead of the Fair value originating under IFRS. Therefore the way out is appropriately amending the Fair value definition in the accounting standards or at least issuing an appropriate guidance for accepting the ALP computation so as to reduce the complexities.
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